Businesses run on the sole motive of keeping growing consistently and earning profits. But all days are not the same. They face some difficulties. What is important here is to constantly monitor the health of your business, the financial ratios and profit margins. The analysts need to constantly evaluate the firm’s ability to generate profits and add value to shareholders.
Having said this is not enough. These analysts or managers use varied financial metrics to keep a close eye on the operations of the business and the problems within it. Some of the vital metrics which are used to evaluate the business are gross profit margin, net profit margin, and operating profit margin.
Is this the only role of profit margins? No, these profit margins also enable the companies to create pricing strategies for their product or service. This means the companies will price their products or services, keeping in mind the cost incurred in manufacturing and the desired expected profit from those manufactured products.
Now as you are familiar with the basics of profit margin, we will try to know more about one of the vital profit margins which analysts use. That is Gross Profit Margin. To begin with, let’s first know
Here’s What We’ll Cover:
- What is Gross profit?
- What is Gross Margin?
- Gross profit margin formula
- Let’s take an example to understand the Gross Profit Margin analysis.
- Is Your Gross Profit Margin Good or Bad?
What is Gross profit?
Gross profit is a company’s profit which they earn after deducting the costs incurred in manufacturing the product or providing the service they offer. Basically, it assesses a company’s efficiency at using its variable costs in providing goods or services.
Now, since we are clear with the concept of Gross Profit, let’s head towards the concept of Gross Margin.
What is Gross Margin?
Gross Margin, or can even say as Gross Profit Margin, is yet another financial metric that enables you to know how efficiently a business manages its operation. Managers use this financial ratio to assess the efficiency of the production process for one or more products.
Yes, you heard right!
You can calculate the gross profit margin for each individual product your company manufactures, provided you have differentiated the direct cost involved in producing those products from one another.
Now you are clear with the concept of what is Gross Profit Margin.
But how will you calculate it?
Just one simple formula and it’s done.
Gross profit margin formula
Gross Profit margin–Net Sales- Cost of Goods Sold / Net Sales
The calculation of Gross Profit Margin involves two variables : net sales, and the Cost of Goods Sold. We can find both in the income statement of the company. How to arrive at these variables? Let’s dive deeper to know more.
Net Sales–Net Sales is nothing but net revenue which you get after deducting the returns, discounts, and allowances from total sales.
Cost of Goods Sold–Cost of Goods Sold is the sum of production costs of a particular product or service. Only direct costs like material & labor, which are incurred in the production of that product or service, are considered for the calculation of the Cost of Goods Sold. We don’t consider individual costs.
Even for that matter, the other expenses like administrative cost, marketing expenses, fixed costs, etc. are not even considered for the Cost of Goods Sold calculation.
Let’s take an example to understand the Gross Profit Margin analysis.
Say there’s a company named Sharma Textile. Now, according to the latest Income Statement, Sharma Textiles has a Net Sales of $100 million and the Cost of Goods Sold is $80 million.
To which their Gross Profit Margin will be = 100-80/10 = 0.2 or 20%
This means 80% of the firm’s profit was used for the cost of goods sold to manufacture the products and the other 20% is left for other expenses and net profit for the company.
Now, as a manager of Sharma Textiles, how will you use this ratio for analysis?
You have to now compare this 20% with either your firm’s data over the years or you can even compare it with other companies in the same industry. Wondering how this will help you? See, comparing your current Gross profit margin ratio either within your company or with other companies will help you understand your operations, efficiency, and scope of improvement.
Is Your Gross Profit Margin Good or Bad?
Want to know?
Let’s go ahead!
Gross profit margins are so specific to industries. Where on the one hand service-centric industries have a really high Gross profit margin because there is no cost involved in manufacturing the product, the start-ups have low gross profit margin as their operations are new and they did not yet develop efficiencies.
To add to this, even the manufacturers end up with a high gross profit margin reason being the large-scale business driving huge profits.
Through the Gross Profit Margin, we measure the efficiency of a firm’s production process. The higher the Gross profit margin percentage, the higher is the production efficiency lower, the percentage lower is the production efficiency of the company.
To sum up, no matter what the industry is, no matter what products or services are being offered, the important element which you understand and think about is the reason behind high or low efficiency of operations, which is affecting your gross profit margin. Company managers must get to the root cause and examine all the factors which are affecting their gross profit margin. If you lack accounting knowledge, you can still manage your accounts.
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